valuation mergers and acquisition
TRANSCRIPT
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MODULE V
VALUATION
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VALUATION In finance, valuation is the process of
estimating what something is worth. Itemsthat are usually valued are a financialasset or liability. Valuations can be doneon assets (for example, investments in
marketable securities such as stocks,options, business enterprises, or intangibleassets such as patents and trademarks) oron liabilities (e.g., bonds issued by a
company). Valuations are needed formany reasons such as investment analysis,capital budgeting, merger and acquisitiontransactions, financial reporting,
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PRINCIPLES OF VALUATION Book Value
Depreciated value of assets minus outstanding
liabilities Liquidation Value
Amount that would be raised if all assets were soldindependently
Market Value (P) Value according to market price of outstanding stock
Intrinsic Value (V)
NPV of future cash flows (discounted at investors
required rate of return)
Appraisal Value
- it is the value acquired from the independent appraisal
agency. This value is normally based on there lacement cost of assets.
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INTRINSIC VALUATION PROCEDURE
1
1
n
t
t
t
k
CFV
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MERGER AS A CAPITAL BUDGETING
DECISION
Capital Budgeting involves acquiring fixed orlong-term assets
Discounted Cash Flow Approach is used
determine the profitability of an asset or viabilityof a Project
M&A involves acquiring the target firmcomprising a large number of assets and liabilities
It is a very long-term investment
Valuation of the target firm is done in the light ofadditional cash flows generated additionally by
the acquisition
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MERGER AS A CAPITAL BUDGETING
DECISIONSTEPS:-
Determination of Incremental projected Free
cash flows to the firm(FCFF).
Determination of Terminal value Determination of Appropriate discount rate/
cost of capital.
Determination of present value of FCFF Determination of cost of Acquisition
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Methods of Valuation
Asset based valuation Earnings or dividend based
valuation CAPM based valuation
Valuation based on Present Valueof free cash flows
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Assets Based Valuation
The book value of a firm is based on the balance sheet value ofowner's equity or in other words Assets minus liabilities. For assetsvalue to be useful, the target company should have followed aregular depreciation, replacement and revaluation policy. Thereasons for using this method are
It can be used as a starting point to be compared and complemented
by other analysis Where large investment in fixed assets is required to generate
earnings, the book value could be a critical factor especially whereplant and equipment are relatively new.
The study of firm's working capital is also necessary.
However this method suffers from certain disadvantages: It is based on historical cost of the asset which do not bear a
relationship either to value of the firm or its ability to generateearnings.
Some entities may wish to sell only part of their business. In suchcase book value may fall flat.
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Example For example:
Balance sheet of A Ltd
Liabilities Amt Assets Amt
Equity share capital of 100000 Goodwill 20000
Rs 10 each Plant and machinery 100000
General reserve 50000 Stock 40000
Creditors 60000 Debtors 50000
Tax payable 30000 Cash at bank 30000
Total 240000 Total 240000
Goodwill is worth nothing. Plant and machinery is valued at Rs 85000. Sundry debtors declared insolvent owed Rs5000. Compute value per share.
Solution: Calculation of net worth
Goodwill -
Plant and machinery 85000
Stock 40000
Debtors 45000
Cash at bank 30000
Less:
Creditors (60000) Tax payable (30000)
Net worth (Rs.) 110000
No. of shares 10000
Value per share (Rs/share) 11
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Earnings based Valuation
There are two methods here. Capitalization of earnings and PE
based value. Capitalization of Earnings
Example:
Profit available for equity shareholders(Rs.) = 225000
No. of equity share = 10000
Earning Per share (Rs/share) = 22.5
Normal Return on Investment = 16%
Value per share (22.5/16%) = Rs 140.625per share
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P/E BASED VALUATION
The market value of equity share is the product of "Earning
per share (EPS) " and the "Price Earnings Ratio". According tothis approach the value of the prospective acquisition
depends on the impact of the merger on the EPS. There could
either be positive impact or a dilutive impact. Prima facie,
dilution of the EPS of the acquiring firm should be avoided.
However, the fact that the merger immediately dilutes the
current EPS need not necessarily make the transaction
undesirable. However the prevailing PE in the market may not
always be feasible. Some aspects that will influence the
valuer's choice of PE ratio include: Size of the target company
In case of unlisted companies, there would be restricted
marketability and the PE multiple will tend to be lower than
listed company
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Dividend Based Valuation
Quite often, the amount of dividend paid is taken as the base for
deriving the value of a share. The value on the basis of the dividendcan be calculated as
No growth in Dividends
S = D1/Ke
where,
S - Current share price
D1 - Dividend
Ke - cost of equity
Constant Growth in Dividends S = [Do(1+g)] / (Ke-g)
where,
Do - Dividend of last year
g - Expected growth rate
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CAPM based valuation
The Capital Asset pricing model can be used to value the
shares. This method is useful when we need to estimatethe price for initial listing in the stock exchange. The cruxof this model is to arrive at the cost of the equity and thenuse it as the capitalization of dividend or earning to arriveat the value of share.
The formula is: ke = Rf + beta of the firm (Rm-Rf)
where,
Ke cost of
equityRf - Risk free rate of
returnRm - Market rate of return.
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Free Cash flow model
Free cash flow model facilitates estimating the maximum worthwhile price that one may pay
for a business. Free cash flow analysis utilizes the financial statements of the target-business,
to determine the distributable cash surpluses, and takes into account not merely the additional
investments required to maintain growth, but also the tie-up of funds needed to meet
incremental working capital requirements. Under this model value of the firm is estimated by
a three step procedure:
Determine the free future cash flows: Net
operating income + Depreciation - incremental investment in capital or current asset for each
year separately. Determine terminal cash flows, on the assumption that there would be constant growth, or no
growth.
Present values these cash flows can then be compared with the price that we would pay for the
acquisition..
However while estimating future cash flows, the sensitivity of cash flows to various factors
should also be considered.
Fair Value
Instead of placing reliance on a single method, it preferable to base our valuation on the
average of results of two or three types discussed above. Normally fair value is ascertained as
the average of net asset value (NAV) per share and the capitalized value of earnings per share
(EPS). This particular method is also known as Berliner Method.
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VALUATION METHODS
When valuing a company, three techniques are
commonly used: comparable company analysis (or"peer group analysis", "equity comps", " tradingcomps", or "public market multiples"), precedenttransaction analysis (or "transaction comps", "deal
comps", or "private market multiples"), and discountedcash flow ("DCF") analysis. A fourth type of analysis, aleveraged buyout ("LBO") analysis, is often used toestimate the amount a financial buyer would pay for acompany. A fifth type of analysis, a sum-of-the-parts("SOTP" or "break-up") analysis may be used to value acompany as the sum of the values of its compositebusinesses.
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VALUATION METHODS
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VALUATION METHODS
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VALUATION APPROACHES Discounted Cash Flow determines the value of the
firm by ascertaining the present value of futurecash flows
Comparable Firm determines the value of the firm
at the value of a similar firm in the same industry Adjusted Book Value estimates the value of the
firm at the sum of market value of assets and
liabilities as a going concern
Option Pricing Model regards the equity of a
taken over company as an option and values it
like an option
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Approaches to ValuationValuation Models
Asset BasedValuation Discounted Ca shflowModels Relative Valuation Contingent ClaimModels
LiquidationValue
ReplacementCost
Equity ValuationModels
Firm ValuationModels
Cost of capital
approach
APV
approach
Excess Return
Models
Stable
Two-stage
Three-stageor n-st age
Current
Norma lized
Equity
Firm
Earnings BookValue
Revenues Sectorspecific
Sector
Market
Option todelay
Option toexpand
Option toliquidate
Patent UndevelopedReserves
Youngfirms
Undevelopedland
Equity introubledfirm
Dividends
Free Cashflowto Firm
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Discounted Cash Flow Valuation What is it: In discounted cash flow valuation, the value of an
asset is the present value of the expected cash flows on the
asset. Philosophical Basis: Every asset has an intrinsic value that
can be estimated, based upon its characteristics in terms of
cash flows, growth and risk.
Information Needed: To use discounted cash flow valuation,you need
to estimate the life of the asset
to estimate the cash flows during the life of the asset
to estimate the discount rate to apply to these cash flows to
get present value
Market Inefficiency: Markets are assumed to make mistakes
in pricing assets across time, and are assumed to correct
themselves over time, as new information comes out about
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Discounted Cashflow Valuation: Basis
for Approach
where CFt is the cash flow in period t, r is the discountrate appropriate given the riskiness of the cash flow andt is the life of the asset.
Proposition 1: For an asset to have value, the expectedcash flows have to be positive some time over the life
of the asset.Proposition 2: Assets that generate cash flows early in
their life will be worth more than assets that generatecash flows later; the latter may however have greatergrowth and higher cash flows to compensate.
Value =CF
t
(1+ r)t
t =1
t = n
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I. Equity Valuation The value of equity is obtained by discounting expected cashflows to
equity, i.e., the residual cashflows after meeting all expenses, tax
obligations and interest and principal payments, at the cost of equity, i.e.,
the rate of return required by equity investors in the firm.
where,
CF to Equityt = Expected Cashflow to Equity in period t
ke= Cost of Equity
Forms: The dividend discount model is a specialized case of equity
valuation, and the value of a stock is the present value of expected future
dividends. In the more general version, you can consider the cashflows left
over after debt payments and reinvestment needs as the free cashflow to
equity.
Value of Equity =CF to Equity t
(1+ ke )t
t=1
t=n
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II. Firm Valuation Cost of capital approach: The value of the firm is
obtained by discounting expected cashflows to the firm,i.e., the residual cashflows after meeting all operatingexpenses and taxes, but prior to debt payments, at theweighted average cost of capital, which is the cost ofthe different components of financing used by the firm,weighted by their market value proportions.
APV approach: The value of the firm can also bewritten as the sum of the value of the unlevered firmand the effects (good and bad) of debt.Firm Value = Unlevered Firm Value + PV of tax benefits of
debt - Expected Bankruptcy Cost
It is variant of DCF, is value of the target company if itwere entirely financed by equity plus the value of theimpact of debt financing in terms of the tax benefits aswell as bankruptcy cost.
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DCF Valuation Model
Cash flowsFirm: Pre-debt cashflowEquity: After debt
cash flows
Expected GrowthFirm: Growth inOperating EarningsEquity: Growth inNet Income/EPS
CF1 CF2 CF3 CF4 CF5
Forever
Firm is in stable growth:Grows at constant rate
forever
Terminal Value
CFn.........
Discount RateFirm:Cost of Capital
Equity: Cost of Equity
ValueFirm: Value of Firm
Equity: Value of Equity
DISCOUNTED CASHFLOW VALUATION
Length of Period of High Growth
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RELATIVE VALUATION What is it?: The value of any asset can be estimated by looking at how the
market prices similaror comparableassets.
Philosophical Basis: The intrinsic value of an asset is impossible (or close
to impossible) to estimate. The value of an asset is whatever the market is
willing to pay for it (based upon its characteristics)
Information Needed: To do a relative valuation, you need
an identical asset, or a group of comparable or similar assets
a standardized measure of value (in equity, this is obtained by dividing
the price by a common variable, such as earnings or book value)
and if the assets are not perfectly comparable, variables to control for
the differences
Market Inefficiency: Pricing errors made across similar or comparableassets are easier to spot, easier to exploit and are much more quickly
corrected.
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RELATIVE VALUATION
In relative valuation, an asset is valued on the
basis of how similar assets are currently priced
in the market.
every thing is relative even when it shouldnt
be. Humans rarely choose in absolute terms.
We dont have an internal meter that tells us
how much things are worth. Rather, we focus
on the relative advantage of one thing overanother, and estimate value accordingly.
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STEPS INVOLVED IN RELATIVE
VALUATION
Analyze the subject company
Select comparable companies
Choose the valuation multiples
Calculate the valuation multiples for
the comparable companies. Value the subject company
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BALANCE SHEET VALUATION MODELS
Book Value: the net worth of a company as shown on the balance sheet.
Liquidation Value: the valuethat would be derived if the firms assets
were liquidated.
Replacement Cost: the replacement cost of its assets less its liabilities.
DIVIDEND DISCOUNT MODELS
31 20 2 3
.......1 (1 ) (1 )
DD DV
k k k
Where Vo = value of the firmDi = dividend in year I
k = discount rate
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The Constant Growth DDM
2
0 0
0 2(1 ) (1 ) ......
1 (1 )D g D g V
k k
And this equation can be simplified to:
0 1
0
(1 )D g DV
k g k g
where g = growth rate of dividends.
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METHODS OF FINANCING MERGERS Cash payment
pay the purchase consideration by cash
Advantages of Cash payment
certain and clearly understood by the target company
improves the chances of a successful bid
Disadvantages of cash payment
raising the necessary cash can be difficult for the bidding company where the target
company is large Shares
issue of ordinary and preference shares
Advantages of purchase by Shares
a voids strain on the cash position of the company
Disadvantages of purchase by Shares
expensive way of raising capital
low gearing
Loan capital
debentures
convertible loans
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METHODS OF FINANCING MERGERS Cash offer:-
It is a straightforward means of financing amerger. It does not cause any Dilution in theearnings per share & the ownership of the
existing shareholders of the acquiringcompany.
It is also unlikely to cause wide fluctuations inthe share prices of the merging companies.
The shareholders of the Target company getcash for selling their shares to the acquiringcompany.
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METHODS OF FINANCING MERGERS
Share Exchange:-
A share exchange offer will result in the sharing of
ownership of the acquiring company between its
existing shareholders and new shareholders.
The earnings & benefits would also be shared
between these two groups of shareholders.
The precise extent of net benefits that accrue to
each group depends on the exchange ratio interms of the market prices of the shares of the
acquiring and the acquired companies.
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TARGET VALUATION
Methods:
Asset-based methods
Balance sheet or net book values approach
P = Total assets - total liabilities
No of ordinary shares issuedNet realisable values or replacement cost
P = net realisable value - total liabilitiesNo of ordinary shares issued
Stock market methods: For listed companies use the share price on the
stock exchange
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TARGET VALUATION
Cash flow methods:
Gordons growth model
Value of share= Dividend received
Rate of returngrowth in dividend
Free cash flow method:
PV of future cash flow-total liabilitiesNo of ordinary shares issued
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TARGET VALUATION
Dividend Yield = Gross dividend per shareMarket value per share
MV/S = Gross dividend per share
Dividend yieldP/E ratio = market value per shareEarning per share
Market value per share = P/E ratio x EPS
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CORPORATE CONTROL
Premium Buybacks
Standstill Agreements
Antitakeover
AmendmentsProxy contests
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Premium buy backs
It represents therepurchase of a substantial
stock holders ownershipinterest at a premium
above the market price(called green mail).
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A standstill agreement
It is written. This represents avoluntary contract in which
the stockholder who is bought
out agrees not to make further
attempts to take over the
company in the future.
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Antitakeover amendments
Are changes in the corporate bylaws to make
an acquisition of the company more difficultor more expensive. These include
Supermajority voting provisions requiring a
high percentage of stockholders to approve amerger,
Golden parachutes which award large
termination payments to existingmanagement if control of the firm is changed
and management is terminated.
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Proxy contest
An outside group seeks to obtainrepresentation on the firmsboard of
directors.
Since the management of a firm
often has effective control of the
board of directors, proxy contests areusually regarded as directed against
the existing management.
Th k ll f
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Thank you all for
listening